ALBERT Einstein described compound interest as “the greatest invention in human history”, “the most powerful force in the universe” and “the eighth wonder of the world”.
“He who understands it, earns it. He who doesn’t, pays it.” Although it is probably false, I felt it sounded too good to fact check.
So what is compound interest and how is it different from normal interest? Compound interest simply means interest on interest (on interest, on interest) and you will get it automatically as long as you don’t withdraw the interest you are getting on your savings account.
This is how quickly it adds up. Suppose you would deposit RM10 per week for the next 20 years. That means you would save RM520 per year and you would end up with RM10,400 after 20 years if you would withdraw interest each year.
But with an interest rate of 7%, and the help of compound interest, you actually would end up with almost RM23,000 in the bank if you would not withdraw any interest.
Warren Buffet is not only insanely rich because he is a disciplined investor, but also because by now he has been able to enjoy the impact of compound interest for over five decades!
With a horizon of 50 years, even a measly saving of RM10 per week will turn into a whopping RM226,000, instead of RM26,000 without compounded interest!
A difference of RM200,000! Of course, you won’t get 7% on your savings account, but if you are a passive, long-term investor with a diversified portfolio, a 7% return on your investment is far from extraordinary.
Now, this will mess with your mind: what if instead of saving RM10 a week, you spend it on things you would hardly remember the next day, let alone years from now?
RM10 a week is not much more than a single coffee or a few snacks. However, these tiny weekly guilty pleasures do leave you RM23,000 poorer in 20 years from now.
So, what would you rather have? RM23,000 in your savings account 20 years from now, or 1,000 drinks spaced out over the next 20 years?
Because of compound interest, the drinks don’t cost you RM10, but RM23 instead! Spending today means you are borrowing from your future self and are reducing your future consumption!
With a 4% interest rate, it will take around 17.5 years for a single ringgit to have doubled to RM2. The higher the interest rate, the shorter it takes for money to double.
With a 7% interest rate, it takes slightly more than 10 years for your ringgit to double.
But of course, that also means that every ringgit you are spending, and not saving, would have doubled in 10 years. This means that everything you are buying today is actually twice as expensive as the listed price, because of the lost saving that it represents.
Of course, you have to take into account that money in the future is typically less valuable than money today because inflation devalues it.
Compound interest also works the other way around. If you have a loan and you are not at least paying off the interest charges, compound interest will guarantee your debt will grow in exactly the same way as your savings would have grown.
This means a 7% loan would double in size in roughly 10 years if you wouldn’t make any payments. This is what Einstein meant with “he who doesn’t understand it pays it”.